Many studies have attempted to build rational asset pricing models. Reinganum (1981) argued that the cross-section of the average returns on U.S. common stocks show little relation to the market β of the Capital Asset Pricing Model described in Sharpe (1964) and Lintner (1965). Fama and French (1992a) reported joint roles of market β, size, earnings-to-price, leverage, and book-to-market equity in cross-sectional of average stock returns. Fama and French (1992b) went on to document that size and book-to-market equity are related to economic fundamentals. Later, Fama and French (1993, 1996) used excess returns on portfolios with size and book-to market equity as the dependent variables in their time-series regressions.
By employing the Fama and French three-factor model, Eberhart and Siddique (2002) analyzed the long-term abnormal returns of corporate bonds and stocks following seasoned equity offerings. They stated the significance levels of all abnormal stock and bond returns
with standardized and unstandardized methods except for those for value-weighted stocks returns with unstandardized methods.1 Eberhart, Maxwell, and Siddique (2004) also used the Fama and French three-factor model and the Carhart four-factor model by adding a momentum factor to find the long-term abnormal returns following R&D increases. The long-term abnormal returns were both found to be significantly positive.
The relationship between financing and investment has been discussed in past studies.
For instance, Modigliani and Miller (1958) argued that the financing and investment decisions are separate processes. In other words, when the condition was given certain simplifying assumptions – no tax, no transaction costs and so on, the value of a firm was independent of its capital structure. Nevertheless, Jensen and Meckling (1986) argued that the potential interaction was between the investment and financing decisions. Some authors seemed to support this point of view; for instance, by relaxing the assumption of a tax-free world, Modigliani and Miller (1963) stated that the value of the firm increased with leverage because of the tax deductibility of the interest payment. In addition, Jensen (1986) noted that debt that reduced the free cash flow available to managers could go against managerial discretion.
Hence, the potential agency and tax benefit of debt may exert a positive influence on the investment of firms. In recent studies, Szewczyk, et al. (1996) found that R&D-induced abnormal returns were positively related to the percentage increase in R&D spending, the debt ratio and institutional relationships, and Zantout (1997) pointed out that abnormal stock returns upon announcements of planned R&D expenditure increases were positively related to the debt ratio. Ho, Tjahjapranata, and Yap (2006) showed that nonsignificantly ambiguous results were found for the independent effect of financial leverage on R&D investment in generating growth opportunities.
1 The returns and risk factor were standardized each month by the cross-sectional standard deviation of all the returns in the portfolio each month and the standard errors of unstandardized returns were corrected for heteroskedasticity and autocorrelation.
According to Jensen and Meckling (1976), agency costs were associated with debt.
Agency cost problems occurred when the interests of the debt holders (principal) and managers (agent) could not be aligned in an R&D investment which resulted in underinvestment. Hence, debt holders would demand a premium that raised the cost of the debt, and the value of the investment would be reduced. In addition to agency cost problems, information asymmetries also reduced the attractiveness of the investments. Outside investors (debt holders) might have overestimated the investment risk when managers raised the level of leverage; in fact, managers might have withheld information to maintain confidentiality for competitive reasons. Bhagat and Welch (1995) observed a negative association between the debt ratio of firms and the R&D investment effect on the value of those firms. Myers and Majluf (1984) presented a “pecking order” model to explain corporate financing decisions and noted that managers used excess cash flows to pay off debt when the profitability of the investment was high; conversely, the firm borrowed money to fund investment when the profitability of the investment was low, so that the debt level might have gone up.
As to whether the abnormal return differs among the different categories of firms has been a focus of many authors. For instance, Chan, Martin, and Kensinger (1990) suggested that high-technology firms that announce increases in R&D spending experienced positive abnormal returns on average, whereas announcements by low-technology firms were associated with negative abnormal returns. Furthermore, in cross-sectional analyses, higher R&D intensity than the industry average led to larger stock-price increases only for firms in high-technology industries.
With regard to R&D innovation, Chang and Shih (2004) found that the comparison of the innovation systems of Taiwan and China revealed that each had unique structural characteristics, as well as numerous complementary features and other phenomena. Their study also suggested the possibility of future cooperation between the two sides on science
and technology subjects. For instance, China is still in the catch-up stage and thus needs to import technology; however, Taiwan has successfully established several high-tech industries and developed relevant technology. Thus, Taiwan could help China develop its technologies and benefit from cooperation with China to increase the economic scale of its manufacturing capacity. Mathews (2001) stated that several alliances had been formed in Taiwan in the late 1990s through the bringing together of firms and public sector research institutes with the added organizational input of trade associations and catalytic financial assistance from the government.2